What constitutes operational activities in the underground economy?

What constitutes operational activities in the underground economy?

Sam Choon Yin (August 2004)


In this essay, I want to define what could be constituted as operational activities in the underground economy (UGE). The UGE is often referred to as that part of the economy which escapes the detection from the public authority. Accordingly, the UGE is not recorded in the country’s national income statistics. The other part of the economy is measured and recorded by the government.

A large magnitude of the UGE is often touted as unhealthy to the country because it hides important information from the government and disables public officers from executing the right policies to stabilise the country. The UGE essentially distorts the true economic status of the country’s economy.

The above definition of the UGE incorporates those activities that are legal for it is in the interest of the government to measure the output of legal and supposedly productive market-based activities. An extensive illegal sector should not be much of a worry here as far as its impact on the national income statistics is concerned since its activities are in the first place not incorporated by the government when it computes the country’s national income (for example, sales of pirated goods and illegal gambling are excluded in the conventional method of calculating the national output).[i]

In theory, the legality of the activities is determined by the society in accordance to the people’s interest. But ascertaining the public’s interest is generally difficult because the public involves many people, some of whom may possess conflicting interest and different ideologies in terms of what should and could be considered as legal or otherwise. As such, political leaders are usually ‘chosen’ to represent the public.

In a democratic society, the politicians are elected to represent the people. They are entrusted with the power to make decisions on behalf of the citizens. Public choice theorists like James Buchanan and Gordon Tullock have however, warned of the possibility of public officers misusing the power entrusted to them and making decisions that maximize their personal interest rather than those of the citizens which they supposedly represent.

Nevertheless, let us assume that a particular country has successfully segregated the activities accordingly into legal and illegal ones. Laws have also been written to stipulate the distinction, and enforced by the judicial system and public officers. In this respect, any legal activities that escape the detection from the public authority are considered operational activities in the UGE (according to the definition of the UGE mentioned earlier). They are supposed to be, but not detected by, and reported to the government.

            Looking at this narrow definition of the UGE, only legal and productive activities are considered. Illegal activities, regardless of their extensiveness, have no direct impact on the size of the UGE. Is this an acceptable proposition? The answer is no according to institutional economists like Edgar Fiege.

Institutional economists have defined the UGE as those activities that have failed to comply with the formal rules. In this respect, the UGE not merely includes activities that are in violation of rules and regulations within the legal sector (which could be referred to as the unrecorded economy), but also those that are in violation of formal rules within the illegal sector. The illegal sector includes the criminal economy and non-criminal economy.

The institutional approach expands the analysis of the UGE to take into consideration the illegal sector (and ‘unproductive’) despite the fact that it does not contribute to the country’s gross domestic product. The relevant question to ask then is why is it important to take into account the seriousness of illegal activities like illegal gambling and prostitution. There could be several reasons.

First, the broader definition of the UGE allows us to examine why some governments allow the illegal sector to flourish while others do not. In some countries, it is relatively easier for one to purchase low-priced goods and services from petty traders although it is considered illegal. The authority may have deliberately allowed petty traders to operate because of the benefits the illegal sector brings to the country. For example, the sector generates employment opportunities to the people which could be useful during times of hardship and economic recessions. If the perceived benefits outweigh the costs, the government may allow such illegal activities to operate particularly if no better alternatives are available.

But they could be instances where illegal activities flourish because the government fails to curb their growth. For example, purchasing of pornographic materials, gambling and visiting the prostitutes are possible in some places because curbing their growth is difficult particularly if the operators could obtain the support from prominent businessmen and politicians. The latter may ensure the existence of the activities in exchange for votes during the elections, as well as additional income to support their lavish lives.

It may be useful to note that with the advancement of technology, the tendency for illegal activities to emerge could increase. The above essentially illustrates that a broader definition of the UGE may be useful and relevant so as to enable us to understand better the root causes of their existence.

Second, the government may be interested to detect the illegal activities to enhance its understanding of the criminal sector. Activities in this sector wilfully inflict harms on the society. They include working class crimes like murdering, kidnapping, stealing, assaulting, protesting and workplace sabotaging, and capital class crimes like extorting, bribing, polluting the environment, price fixing, money laundering, gambling and human trafficking. In addition to measuring the seriousness of these activities, it is in the interest of the public officers to understand the reasons why they emerge and expand, so that corrective actions can be introduced to contain their growth.

Third, detecting the illegal sector enables the government to improve on the economic statistics like the unemployment and inflation data. As was mentioned earlier, the illegal sector generates employment opportunities to the people. As such, the recorded unemployment rate may overstate the true status. The reason being that those who are supposed to be unemployed – as recorded – could actually be gainfully employed in the illegal sector. Likewise, the recorded inflation rate may overstate the true inflation rate of the country if ‘similar’ goods and services can be bought in the illegal sector at a lower price. The latter is possibly true because the operators in the sector face lesser restrictions and regulations (hence lower transaction costs are incurred). Lower rental rates, no payments of taxes and possibly no payments of bribes, could help the traders further in lowering their operational costs (the aboveground operators nay not enjoy such benefits). The illegal operators could pass on the benefits to the consumers in the form of lower prices.

Hence, having information on the illegal sector allows the government to understand better the economy it manages.

To sum up, our discussion above shows that it is technically more demanding to understand the UGE when one considers the institutional approach since more issues are being covered. Some may view the institutional definition of the UGE to be more appropriate. It does broaden our analysis on the issues in consideration to include activities that are in violation of formal rules - encompassing those in the unrecorded economy, criminal economy and non-criminal economy (the latter two are in the illegal sector).


[i] One should note that non-market based activities like doing household chores by housewives are also excluded from the national income by convention.